Markit Credit Indices A Primer November 2008

Markit Credit Indices
A Primer
November 2008
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Confidential. Copyright © 2008, Markit Group Limited. All rights reserved. www.markit.com
Markit Credit Indices Primer
Copyright © 2008 Markit Group Limited
Any reproduction, in full or in part, in any media without the prior written permission of Markit Group
Limited will subject the unauthorized party to civil and criminal penalties.
Trademarks
Mark-it™, Markit™, Markit CDX™, Markit LCDX™, Markit ABX, Markit CMBX, Markit MCDX, Markit
Loans™, Markit RED™, Markit Connex™, Markit Metrics™ iTraxx®, LevX® and iBoxx® are trademarks of
Markit Group Limited. Other brands or product names are trademarks or registered trademarks of their
respective holders and should be treated as such.
Limited Warranty and Disclaimer
Markit specifically disclaims any implied warranty or merchantability or fitness for a particular purpose.
Markit does not warrant that the use of this publication shall be uninterrupted or error free. In no event
shall Markit be liable for any damages, including without limitation, direct damages, punitive or exemplary
damages, damages arising from loss of data, cost of cover, or other special, incidental, consequential or
indirect damages of any description arising out of the use or inability to use the Markit system or
accompanying documentation, however caused, and on any theory of liability.
This guide may be updated or amended from time to time and at any time by Markit in its sole and
absolute discretion and without notice thereof. Markit is not responsible for informing any client of, or
providing any client with, any such update or amendment.
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Markit Credit Indices Primer
Scope of the document
This document aims to outline the different credit indices owned and managed by Markit, their
characteristics and differences, and how they trade. We focus on synthetic indices backed by single
name bonds CDS (senior unsecured) and single name loans CDS (senior secured): the Markit CDX and
Markit iTraxx for bonds, and the Markit iTraxx LevX and Markit LCDX for loans. We purposely do not
cover synthetic structured indices, such as the ABX and the CMBX, as their functioning is quite different.
Table of Contents
Section 1 – Credit Default Swaps
Definition
4
Types
5
Uses
5
Pricing
6
Notional
6
Section 2 – Credit Indices
A Brief History
7
Benefits
7
Participants
7
Key Characteristics
7-9
Rules
9-10
Section 3 – Trading Credit Indices
Trading Overview
11
Valuation
12
Credit Events
12-13
Section 4 – Tranches
14
Conclusion
15
Appendices
Appendix 1 – Roadmap to Credit Indices
16-18
Appendix 2 – Index Roll Timeline
19-24
Appendix 3 – Roadmap to Tranches
25
Appendix 4 – Credit Derivatives Glossary
25-31
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Markit Credit Indices Primer
Section 1 – Credit Default Swaps
Definition
A Credit Default Swap (CDS) is a contract between two parties, a protection buyer who makes fixed
periodic payments, and a protection seller, who collects the premium in exchange for making the
protection buyer whole in case of default. In general trades are between institutional investors and
dealers.
CDS are over-the-counter (OTC) transactions. They are similar to buying/selling insurance contracts on a
corporation or sovereign entity’s debt, without being regulated by insurance regulators (unlike insurance,
it is not necessary to own the underlying debt to buy protection using CDS). Before trading, institutional
investors and dealers enter into an ISDA Master Agreement, setting up the legal framework for trading.
Each contract is defined by
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A Reference Entity (the underlying entity on which one is buying/selling protection on);
A Reference Obligation (the bond or loan that is being “insured” - although it doesn’t have to
be the deliverable instrument in a default situation and doesn’t have to have the same
maturity as the CDS, it designates the lowest seniority of bonds that can be delivered in case
of default);
A Term/Tenor (5 years are the most liquid contracts);
A Notional Principal;
Credit Events (the specific events triggering the protection seller to pay the protection buyer –
The defined events are bankruptcy, failure to pay, debt restructuring, and the rare obligation
default, obligation acceleration, and repudiation/moratorium).
Markit Reference Entity Database (RED) is the market standard that confirms the legal relationship
between reference entities that trade in the credit default swap market and their associated reference
obligations, known as “pairs”. Each entity is identified with a unique 6-digit alphanumeric code, and a 9digit code identifies the pair. RED codes are widely and successfully used by CDS market participants to
electronically match and confirm CDS transactions. The RED “preferred reference obligation” is the
default reference obligation for CDS trades based on liquidity criteria.
In case of a credit event, under standard physical settlement the protection buyer has to deliver a bond of
seniority at least equal to that of the reference obligation – if there are multiple bonds deliverable, the
protection buyer will most likely deliver the cheapest bond to the protection seller. We can represent the
life of a CDS with the following cash flows:
From initiation of trade to maturity if there is no credit event:
Fixed Quarterly Cash Payments
Default
(basis points per annum)
Default
Protection
Protection
Buyer
Seller
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Markit Credit Indices Primer
In case of Credit Event
Reference Obligation at x% of par
+
Accrued CDS Interest
Default
Default
Protection
Protection
Buyer
Seller
100% of par of the underlying
Reference Obligation
Note that a market-wide cash settlement mechanism has been implemented in recent years. More details
will be covered under Auctions later.
Types
The different types of CDS contracts traded:
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CDS: indicates that the underlying reference entities and obligations are senior unsecured
bonds, issued by corporate or sovereign issuers
LCDS: Loan-only CDS refers to contracts where protection is bought and sold on syndicated
secured leveraged loans. These are higher in the capital structure (and with higher recovery
rates) than CDS.
MCDS: The reference entity is a municipality, and the reference obligation a municipal bond.
ABCDS: CDS on structured securities (Asset Backed Securities typically)
Preferred CDS: CDS on Preferreds
Uses
Hedging
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CDS allow capital or credit exposure constrained businesses (banks for example) to free up
capacity to facilitate doing more business.
CDS can be short credit positioning vehicle. It is easier to buy credit protection than short
bonds.
For LCDS, counterparties can assign credit risk of bank loans without requiring consent of
lender (assigning bank loans often requires borrower consent/notification), therefore CDS
reduce bank exposure to credit risk without disturbing client relationships.
CDS may allow users to avoid triggering tax/accounting implications that arise from sale of
assets
Investing
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Investors take a view on deterioration or improvement of credit quality of a reference credit
CDS offer the opportunity to take a view purely on credit
CDS offer access to hard to find credit (limited supply of bonds, small syndicate)
CDS allows investors to invest in foreign credits without bearing unwanted currency risk
Investors can tailor their credit exposure to maturity requirements, as well as desired seniority
in capital structure
CDS require no cash outlay and therefore creates leverage
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Markit Credit Indices Primer
The standardized documentation, liquidity, ability to customize terms, and pure credit focus has made the
CDS market a de facto standard for expressing a view on the credit market (either single credits, or
baskets such as indices).
Pricing
CDS contracts in general trade based on a spread, which represents the cost a protection buyer has to
pay the protection seller (the premium paid for protection). The protection buyer is said to be short the
credit as the value of the contract rises the more the credit deteriorates.
The value of the CDS contract increases for the protection buyer if the spread increases. For example, a
protection buyer paying a spread of 60bps when the current spread is 90bps would be able to unwind the
position at a higher spread level.
Estimated recovery is a key part of valuing a CDS contract, as it represents the value post-default, and
therefore impacts expected cash flows. For investment grade names, recovery is generally assumed to
be 40% (as the probability of default is low, the recovery rate is at best an estimate). For distressed
names however, where the probability of default is higher, recovery tends to be more precisely defined.
Markit offers comprehensive data service including daily credit curves for over 3,500 entity-tiers including
recovery rates, and valuation services to value trades.
Notional
It is important here to note that CDS trades refer to a notional, the quantity of the underlying asset or
benchmark to which the derivative contract applies. It doesn’t refer to any cash exchange at time of trade,
the mark-to-market size of the market. It is akin to the amount of insurance bought, not the premium paid.
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Markit Credit Indices Primer
Section 2 - Credit Indices
A Brief History
Synthetic credit indices originated in 2001 when JPMorgan launched the JECI and Hydi indices, and
Morgan Stanley launched Synthetic TRACERS. Both firms merged their indices under the Trac-x name in
2003. During the same period iBoxx launched credit derivatives indices. In 2004 Trac-x and iBoxx merged
to form the CDX in North America and the iTraxx in Europe and Asia. After being the administrator for the
CDX and calculation agent for iTraxx, Markit acquired both families of indices in November 2007, and
owns the iTraxx, CDX, LevX, and LCDX Indices for derivatives, and the iBoxx indices for cash bonds.
Benefits
Credit indices have expanded dramatically in recent years, with volumes rising, trading costs decreasing,
and a growing visibility across financial markets. Benefits of using CDS indices include:
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Tradability: Credit indices can be traded and priced more easily than a basket of cash bond
indices or single name CDS
Liquidity: Significant liquidity is available in indices and has also driven more liquidity in the
single name market
Operational Efficiency: Standardized terms, legal documentation, electronic straight-through
processing
Transaction Costs: Cost efficient means to trade portions of the market
Industry Support: Credit indices are supported by all major dealer banks, buy-side investment
firms, and third parties (for example, Markit offers transaction processing and valuations
services)
Transparency: Rules, constituents, fixed coupon, daily prices are all available publicly
Participants
There are five main parties involved in credit indices:
ƒ
Markit – Markit owns and operates the indices: including licensing, marketing, administration,
and calculation. Markit publishes prices daily on its website
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Banks – Banks trade indices on their own behalf and provide liquidity for their clients. They
are intimately involved in the indices, actively participating in rolls, and playing a key part in
product development
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Institutional Investors – Investors can hedge their positions, or express views on a specific
market segments via credit indices
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ISDA – Markit and banks have worked with ISDA to create globally approved legal
documentation for CDX, LCDX, iTraxx and LevX indices
ƒ
Third parties – Third parties have made trading credit indices easier by integrating them into
their platform. For example, Markit Trade Processing allows buyside and sellside firms to
communicate and confirm trade details with counterparties, including industry matching
utilities like DTCC’s Deriv/SERV.
Key characteristics
See Appendix 1 for a breakdown of the major credit indices, number of entities included in each index, roll
dates, and maturities available to trade for each index.
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Differences between Bond and Loan-only CDS Indices
Bonds
Loans
Deliverable
Bonds or Loans
Loans only
Cancellability
CDS trade is not cancellable
in cases where all the
underlying debt is called or
matures
CDS trade is cancellable if an
issuer repays all its secured
debt without issuing new
relevant debt
Valuation
Duration is not adjusted for
cancellability
Duration of the index needs to
be reduced to account for the
cancellability of the loans
Credit Event
The three most commonly
used credit events are failure
to pay, bankruptcy and
restructuring. Also defined but
rarely seen are Obligation
Acceleration, Repudiation /
Moratorium
Bankruptcy, Failure to Pay, and
- for LevX only - Restructuring
Differences between LevX and LCDX
LevX
LCDX
th
Roll Date
March and September 20
April and October 3rd
Region
Europe
North America
Reference
Reference Obligation
Reference Entity
Currency
EUR
USD or EUR
Credit Event
Bankruptcy, Failure to Pay,
Restructuring
Bankruptcy, Failure to Pay
Deliverables
LevX includes a Senior (1st
Lien) index, and a Sub (2nd/3rd
Lien) index
LCDX only includes 1st Lien
loans
Loan Criteria
Eligibility
Senior – min EUR500 million
deal
Loans must be on the Markit
Syndicated Secured List *
Sub – min EUR100 million
deal
Entities
Senior – 75 names
100 names
Sub – 45 names
Business
Days
London
and
Settlement Day
TARGET
USD – New York and London
EUR – London and TARGET
Settlement Day
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* Markit’s Syndicated Secured List (SSL) is a database of syndicated secured loans traded in the primary
and secondary markets including information about the priority of such loans gathered from market
participants and other information. Markit RED maintains the SSL.
Differences between iTraxx and CDX
iTraxx
CDX
Region
Europe and Asia
North America and Emerging
Markets
Credit Event
Bankruptcy, Failure to Pay,
Modified Restructuring
Bankruptcy, Failure to Pay
Currency
Europe – EUR
Japan – JPY
Asia ex-Japan – USD
Australia - USD
Liquidity – A liquidity poll
decides
inclusions
and
exclusions
USD, EUR
London
and
Settlement Day
USD – New York and London
Reference
Entities
Business
Days
TARGET
Dealer Poll – Dealers select
reference entities to be added
and removed
EUR – London and TARGET
Settlement Day
Coupon Payments
Payments from the protection buyer to protection seller are made on a quarterly basis (March 20, June
20, September 20, December 20) and accrue on a Actual/360, except for CDX.EM, where payments are
semi-annual, and due on June 20 and December 20.
Rules
Indices roll every six month - a new series of the index is created with updated constituents. The previous
series continues trading although liquidity is concentrated on the on-the-run series.
The roll consists of a series of steps which are administered by Markit:
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Exclusion: a number of entities are excluded from the index. Names no longer qualify
because of a corporate action, ratings changes (for the indices where ratings are a criteria),
lack of liquidity, or by dealer poll results
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Inclusion: New names are added to the each index to keep the number of constituents the
same. Inclusion is decided by a liquidity poll for iTraxx, and a dealer poll for the
CDX/LCDX/MCDX
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Reference obligation assignment: For each entity in the new index, a suitable reference
obligation is identified by Markit RED, with input from the dealers
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Fixed Rate determination: Licensed Dealers determine the spread for each index and
maturity. This is done via a dealer call in Europe and Asia. In North America, the licensed
dealers send Markit an average spread, and the median becomes the fixed spread on the
index. In addition to the fixed rate, iTraxx dealers also agree on a recovery rate used for
upfront calculations (not for the determination of cash flows in case of a credit event)
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Annex: The final annex, stating the composition of each index, and fixed rate is published by
Markit. The annex is attached to each index trade confirmation
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New Series starts trading
Timelines for the rolls of CDX.NA.IG, CDX.NA.HY, and LCDX are given as example in Appendix 2.
The complete rules can be found on Markit’s website:
CDX and LCDX:
http://www.markit.com/information/products/category/indices/lcdx/documentation/contentParagraphs/01/d
ocument/Markit%20CDX%20and%20Markit%20LCDX%20Rules.pdf
iTraxx
http://www.markit.com/information/products/category/indices/itraxx/documentation.html
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Markit Credit Indices Primer
Section 3 – Trading Credit Indices
Trading Overview
Trading Conventions
Indices trade either on spread or on price. It mimics the cash instrument where some bonds trade on
yields, and others on price. The CDS indices convention matches that of the underlying cash instruments.
Spread
Price
CDX (IG, XO, HVOL), iTraxx (Europe, Japan, Asia exJapan, Australia), MCDX
CDX (HY, EM, EM.Div), LCDX, LevX
Intuitively, if an index has a fixed coupon of 60 and the current coupon is 90, it is positive for the
protection buyer (they are paying 60 for something that is currently worth 90). The price is inversely
related to spread so the price of the index at 90 is lower than the price at 60, and as the protection buyer
is short the credit a drop in price is positive.
Where can I trade?
Credit Indices are over-the-counter (OTC) products and can be traded with licensed dealers providing
liquidity. An updated list of banks providing liquidity for the US indices is updated on the URLs shown
below:
http://www.markit.com/information/products/category/indices/lcdx/dealers.html
http://www.markit.com/information/products/category/indices/cdx/contributing_banks.html
How do I trade?
Buying and selling the indices can be compared to buying and selling portfolios of loans or bonds. A
buyer takes on the credit exposure to the loans or bonds, and is exposed to defaults, similar to buying a
cash portfolio (buying the index is equivalent to selling protection). By selling the index, the exposure is
passed on to another party. Exposure is similar in both cases.
The indices trade at a fixed coupon, which is paid quarterly (except for EM which is semi-annual) by the
buyer of protection on the index, i.e. a short index position, and upfront payments are made at initiation
and close of the trade to reflect the change in price. Correspondingly, the protection seller, or buyer of the
index, receives the coupon. The indices are quoted on a clean basis.
Example:
The index launches with a price of 100 on September 20th, and a fixed coupon of 60. Investor A buys
$10,000,000 notional protection on the index on November 30th, when the spread has moved to 90 and
corresponding price is 98.67 (the price is par minus the present value of the spread differences). Investor
A makes an upfront payment to account for the movement in the spreads.
Payment = 10,000,000 * (100-98.67)/100 = $133,000
In addition, he will receive the accrued interest up to trade date (as he will have to make the full coupon
on coupon payment date – this simplifies operations as all protection buyers make the same payment on
the same date): 71 /360 * 10,000,000 * 0.006 = $11,833.3
Net outflow = $121,166.67
December 20th – Investor A pays the fixed coupon.
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Cash outflow = 0.006 * 10,000,000 = $60,000
March 13th – Investor A closes the trade on March 13 when the spread is 120 and the equivalent price is
97.44. Investor A pays the accrued interest up to trade date and receives payment.
Inflow = 10,000,000 * (100-97.44)/100 - 0.006*10,000,000 * 104/360 = 256000 – 17333.33 = $238,666.67
Markit offers a variety of services around trading of single name CDSs and indices. Markit Quotes and
Intraday offer intra-day CDS and indices levels, and Markit Portfolio Valuations provide buyside firms daily
valuations using Markit’s extensive dataset.
Valuation
There are two ways to calculate the theoretical value of an index based on the underlying instruments:
ƒ A simplified model using risky duration only for each credit in the index generates a decent
approximation. This is covered in more detail below.
ƒ The more accurate and complex way is to use the hazard rate model for each underlying
components of the index. It is not a trivial exercise and is outside the scope of this document,
but will generate a more accurate value, as it allows for curvature in the credit spread curve.
For small differences in fixed and current coupon the two valuation methods will have similar results. The
hazard rate model will give better results for large movements in the spread.
Simple valuation example - Take each individual credit, and multiply the risky duration of the credit by the
difference between the current spread of the credit and the coupon of the index. This gives the PV on
each component. The fair value price of the index is 100 minus the sum of all the PV’s across all
constituents.
For example, if the first credit is trading at 200 bps, with a risky duration of 3.75 years, vs. an index
coupon of 150 bps, then the contribution to the index price is 3.75*50/10,000 = 0.01875. If we assume all
other credits are trading at 150 bps (i.e. equal to the index coupon), then the price of the index will be 100
– 0.01875 = 99.98125.
The index will trade away from the intrinsic value calculated above, as it is a tradable index, and market
supply and demand ultimately dictates where the index trades. However the intrinsic value provides a
benchmark. The traded and intrinsic values are both available in Markit’s end-of-day data services.
Credit Events
Events that can trigger a payout from the seller of the index are highlighted in the tables above and
defined in Appendix 4 (Dictionary).
If a credit event occurs, a new version of the index will be issued with the defaulted entity removed and
with a reduced notional (assuming 100 names in the index, the new version will contain 99 names and
will have a revised notional of $9.9 million rather than $10 million). Historically the new version would
immediately become the liquid version, although for the last two credit events (Movie Gallery, Quebecor),
version 2 only started trading after the recovery rate is set. This was due to tranche trading, as the new
attachment and detachment points are dependent on the recovery rate. Trading version 2 only after the
recovery rate is set allows trades to be fungible.
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Credit Events can be settled via two means – physical or cash settlement.
Physical settlement functions the same way as highlighted in the single name CDS section above and
entails the protection buyer delivering the debt and receiving par on the portion of the index made up of
the defaulted reference entity. The protection seller who took delivery of the debt is left holding the
defaulted asset. This is the traditional method of settlement, but runs into problems when the notional of
the outstanding debt is less than the CDS/LCDS outstanding. Additionally, every counterparty might not
be able to take receipt of the debt. For an index, where the notional exposure in many trades for an actual
credit will be small, and investors typically do not own the loan or bond on the credit event date, cash
settlement is a better choice. The mechanics of cash settlement are simpler, faster, and more
operationally efficient than physical settlement, where an actual loan/bond trade takes place.
Cash settlement is conducted by setting the recovery price in an auction, and the compensation received
by the protection buyer is based on the final agreed auction price. Auctions have been developed over
recent years for the unsecured market and have more recently been used in the senior secured market
too. The recovery price is used across the whole market to settle trades, ensuring all contracts are settled
at the same price. For more information on the auctions please see the primer on www.creditfixings.com.
Once a bankruptcy is announced, ISDA coordinates the major participants in the market and agrees an
event determination date. Coupons stop accruing on the defaulted entity on this date.
An auction will most likely be announced for a date approximately three to four weeks after a credit event.
Markit and Creditex administer the auction and publish the results of each step of the process on
www.creditfixings.com
Assuming a recovery of 70 cents on the dollar, all protection buyers are compensated 30 cents in the
dollar on the defaulted name. For LCDX contract holders, where each entity has a 1% weighting in the
index, they are compensated 1% * 0.3 multiplied by the notional of the LCDX trade. For a $10m trade,
this is $30,000.
A complete Credit Event Auction Guide is available at
http://www.creditfixings.com/information/affiliations/fixings/contentParagraphs/00/document/Credit%20Ev
ent%20Auction%20Primer.pdf
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Section 4 – Tranches
Some of the credit indices are also available in a tranched format, which allows investors to gain
exposure on a particular portion of the index loss distribution. Tranches are defined by attachment and
detachment points. Defaults affect the tranches according to the seniority of the tranche in the capital
structure. Example of the CDX.NA.HY tranches:
Super Senior
35-100%
100
Equally Weighted
CDS
Junior Senior
25-35%
Senior Mezz
15-25%
Detachment Point – 15%
Junior Mezz
10-15%
Equity
Attachment Point – 10%
0-10%
Example:
An index has 100 equal weighted names, and has the following tranches: 0-5, 5-8, 8-12. 12-15, 15-100
(in this case the 5-8 tranche has an attachment point of 5 and detachment point of 8). Investor B bought
protection on the 0-5% tranche with a notional of $10 million.
One name defaults – Recovery is set at 65% (35% Loss Given Default – LGD). The payout from the
protection seller is:
(Notional * LGD * Weighting) / Tranche Size
Or $700,000 to Investor B.
The 0-5% tranche is adjusted for the reduced notional (0.35 based on LGD) and 4.65% of the notional
remains. The new detachment point has to be adjusted for the number of remaining names in the index,
using a factor of 0.99 (the 0-5 tranche for new trades now becomes a 0-4.69 tranche). The original
principal of the other tranches is unaffected but now has a smaller cushion protecting them against further
losses.
Markit offers the most comprehensive pricing service for on-the-run and off-the-run tranches, providing
bid, ask, and mid upfronts and spreads, as well as base correlations.
Additional information is available in Appendix 3
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Conclusion
Credit indices are widely used around the world. It is therefore key to understand the basic mechanics
and characteristics of each index and their differences. We have attempted to highlight each index, but if
you need more in-depth information, please contact the following people:
U.S. Credit Indices
Nishul Saperia
Head U.S. Credit Indices
212 931-4931
[email protected]
Marc Barrachin, CFA
Director
914 368-7221
[email protected]
European/Asian Credit Indices Tobias Sproehnle, CFA
Head European & Asian Credit Indices
+49 69 299 868 143
[email protected]
Global Cash Bond Indices
Randolf Tantzscher
Director
+44 207 260 2136
[email protected]
or go to www.markit.com.
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Appendix 2 – Index Roll Timeline
CDX.NA.IG
9am - Markit polls
dealers for fixed
spread for the index at
each maturity
Selection
of 30
names to
be part of
HVOL
Names to be
included in
next index are
submitted by
Dealers
5pm – Markit
publishes fixed rate
Markit
publishes
the Annex
T-5
11am
T-7
T-10
T-3
T-6
T-9
Names to be
excluded from
next index are
submitted by
Dealers
T-2
Final Constituents
List published
&
Markit
publishes
constituents
of HVOL
Roll Date
T-1
5 pm
Annex draft
distributed to
Eligible Members
Markit identifies
Reference
Obligations
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New index
starts trading
Markit Credit Indices Primer
Appendix 2 – Index Roll Timeline
CDX.NA.HY
Names to be
included in
next index are
submitted by
Dealers
Annex draft
distributed to
Eligible Members
Composition of
B and BB
subindices set
New index
starts trading
T-1
T-15
T-12
T-3
T-2
T-6
T-14
Names to be
excluded from next
index are submitted
by Dealers
5 pm
Final Constituents
List published
&
9am - Markit polls
dealers for fixed
spread for the index at
each maturity
Markit identifies
Ratings, Corporate
Actions & Liquidity
are reviewed
Reference
Obligations
5pm – Markit
publishes fixed rate
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Roll Date
Markit
publishes
the Annex
Markit Credit Indices Primer
Appendix 2 – Index Roll Timeline
LCDX
Initial names
to be included
in next index
are submitted
by Dealers
T-12
Markit
publishes
constituents
of new LCDX
and Eligible
Members
Names to be excluded
from next index are
submitted by Dealers
SSL exclusion,
Corporate Actions &
Liquidity are reviewed
T-4
11am
Final Constituents
List determined
New index
starts trading
T-1
5 pm
T-3
T-9
T-10
Annex draft
distributed to
Eligible Members
T-2
1pm - Markit polls
dealers for fixed
spread for the index at
each maturity
5pm – Markit
publishes fixed rate
21 of 31
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Roll Date
Markit
publishes
the Annex
Markit Credit Indices Primer
Appendix 2 – Index Roll Timeline
MCDX
Initial names to
be included in
next index are
submitted by
dealers
T-12
Annex draft
distributed to
Eligible Members
T-9
Names to be
excluded from next
index are submitted
by dealers
T-1
5 pm
T-3
T-2
T-10
Final constituents
list determined and
published
New index
starts trading
1pm - Markit polls
dealers for fixed
spread for the index at
each maturity
5pm – Markit
publishes Fixed Rate
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Roll Date
Markit
publishes
the Annex
Markit Credit Indices Primer
Appendix 2 – Index Roll Timeline
iTraxx Europe and Crossover
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Markit Credit Indices Primer
Appendix 2 – Index Roll Timeline
iTraxx LevX
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Appendix 3
Tranches
Index Tranches Availability
Tranches are available for the following Indices:
Index Name
Tranches
CDX.NA.HY
0-10, 10-15, 15-25, 25-35, 35-100
CDX.NA.IG
0-3, 3-7, 7-10, 10-15, 15-30, 30100
iTraxx Europe
0-3, 3-6, 6-9, 9-12, 12-22, 22-100
iTraxx Europe XO
0-10, 10-15, 15-25, 25-35, 35-100
iTraxx Japan
0-3, 3-6, 6-9, 9-12, 12-22
iTraxx Asia ex-Japan
0-3, 3-6, 6-9, 9-12, 12-22
iTraxx Australia
0-3, 3-6, 6-9, 9-12, 12-22
LCDX
0-5, 5-8, 8-12, 12-15, 15-100
A detailed description of tranches for LCDX can be found on
http://www.markit.com/information/products/category/indices/lcdx/tranches/contentParagraphs/01/docume
nt/Markit%20LCDX%20Tranches%20Presentation.pdf
Pricing
LCDX – Bottom two tranches trade upfront only. Other tranches trade on spread.
CDX.HY – Bottom two tranches Trade upfront only. Other tranches trade on spread.
CDX.IG – Bottom tranche trades upfront with running spread. Other tranches trade on spread.
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Markit Credit Indices Primer
Appendix 4
Credit Derivatives Glossary
ABCDS – A CDS where the underlying is an Asset Backed security.
Asset Swap Spread – An asset swap involves a swap of a fixed rate in return for a floating rate. The
fixed rate is derived from an asset. The floating rate is composed of a spread over LIBOR (or another
floating benchmark). The asset swap spread (gross spread) is derived by valuing a bond's cash flows via
the swap curve's implied zero rates. This gross spread is the basis point amount added to the swap
curve, which causes a bond's computed value to equal the market price of the bond. It is comparable to a
CDS spread in that it is interest rate insensitive.
Basis Point – 1/100th of 1%. 100 basis points = 1%. A common term in fixed income and credit
derivatives markets.
Basket CDS – A CDS where a group of reference entities are specified in one contract. There are several
types of basket CDS including first or Nth-to-default swaps (where settlement is triggered when the first or
Nth entity defaults) and add-up default swaps where settlement is contingent on all of the entities in the
basket.
Binary CDS – (Also called a digital default swap) A CDS where the recovery is fixed.
Calculation agent – The party responsible for determining when a credit event has occurred, and
calculating the amount of payment required by the Protection Seller.
CDS Spread – Also called a premium. The amount paid by the Protection Buyer, typically denominated in
basis points and paid quarterly.
Contingent CDS – A CDS in which settlement requires both a credit event and another trigger (e.g. credit
event in another reference entity or specified movement in some market variable). These are rare.
Credit Default Swap (CDS) – A credit derivative transaction in which two parties enter into an
agreement, whereby one party (known as the Protection Buyer) pays the other party (the Protection
Seller) periodic payments for the specified life of the agreement. The Protection Seller makes no
payment unless a credit event relating to a predetermined reference asset occurs. If such an event
occurs, it triggers the protection seller’s settlement obligation, which can be either cash or physical, as
more particularly described below.
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Markit Credit Indices Primer
Derivative – A broad term describing financial instruments that “derive” their value from an underlying
asset or benchmark. Many derivatives are designed to transfer some form of risk from one party to
another and can involve varying amounts of leverage. Included in this broad definition would be: Futures,
Options (including caps and floors), Swaps (including CDS and interest rate swaps), Forwards, Floaters
and hybrids of the above.
CFTC – Commodities and Futures Trading Commission – U.S. regulator charged with oversight of
commodities and financial futures and options contracts.
Credit Event – This is the event triggering settlement under the CDS contract. Since the original ISDA
Agreement in 1999, 6 categories of credit events have been defined:
•
Bankruptcy – Although the ISDA 2003 Definitions refer to different ways a bankruptcy can occur,
the experience has been that the reference entity has filed for relief under bankruptcy law (or
equivalent law).
•
Failure to pay - the reference entity fails to make interest or principal payments when due, after
the grace period expires (if grace period is applicable in the trading documentation).
•
Debt restructuring - the configuration of debt obligations is changed in such a way that the credit
holder is unfavorably affected (maturity extended and/or coupon reduced).
•
Obligation default, obligation acceleration, and repudiation/moratorium – the 2003 ISDA
definitions define these three credit events, but they are very rare.
Credit Spread (Cash) – It is the spread to be added to a benchmark rate to compensate an investor for
taking credit risk on a particular instrument. In general the benchmark rate is LIBOR.
Credit Spread Curve – The curve display of the credit spread for a unique reference
entity/tier/currency/docclause combination over different tenors. Find below a picture of a Caterpillar
credit spread curve from Markit’s CDS pricing service:
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Markit Credit Indices Primer
Restructuring Clause - Defines the credit events that trigger settlement. This is a key element as CDS
spreads are higher for contracts with a broader range of credit events (i.e. more events can trigger the
payment to the Protection Buyer, therefore the CDS protection is more valuable), and/or fewer restrictions
on the Protection Buyer’s settlement obligations (i.e. the more flexibility a Protection Buyer has to deliver
a bond, the more valuable the CDS contract). Variations include:
CR – Complete Restructuring (a.k.a. full restructuring, FR): Any restructuring event qualifies as a
credit event and any bond of maturity up to 30 years is deliverable. This is standard for EM and
MCDX trades. It was the standard for IG and HY trades but was replaced by MR in 2001.
MR – Modified Restructuring: Restructuring agreements count as a credit event, but the
deliverable obligation against the contract has to be limited to those with a maturity of 30 months
or less after the termination date of the CDS contract or the reference obligation that is
restructured (regardless of maturity). Generally used for IG trades in the US. This doc-clause
started in 2001.
MM – “Modified-Modified” restructuring: In 2003, market participants in Europe found the 30
months limit on deliverable bonds to be too restrictive, so MM was introduced with a maturity limit
of 60 months for restructured obligations and 30 months for all other obligations. This is used
mostly in Europe.
XR – No Restructuring (a.k.a. NR): All restructuring events are excluded as trigger events. This is
prevalent in the high yield market.
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Markit Credit Indices Primer
DTCC – Depository Trust & Clearing Corporation provides clearance, settlement and information services
for equities, corporate and municipal bonds, government and mortgage-backed securities and over-thecounter credit derivatives. The credit default swaps matching and confirmation service provides
automated, real-time matching and confirmation for standard single reference entity credit default swaps
(including North American, European, Asian corporate credits, and sovereign credits), as well as credit
default swap indices. The automated system currently supports new trades, full terminations, partial
terminations and assignments (i.e., the assignment of the contract from one party to another, also called
novation) through a fully automated environment.
Entity Pair – Refers to the combinations of reference entities and reference obligations, which are
described by the full 9 digit Markit RED™ code. One reference obligation may have more than one Entity
Pair. Entity Pairs also identify the Tier (see below). For each Tier, there is a ‘Preferred’ Entity Pair, defined
as the most liquid. Here is an example:
ISDA – The International Swaps and Derivatives Association is the global trade association representing
participants in the privately negotiated derivatives industry, a business covering swaps and options
across all asset classes (interest rate, currency, commodity and energy, credit and equity). ISDA was
chartered in 1985, and today numbers over 670 member institutions from 50 countries on six continents.
The membership includes associated service providers and consultants.
LCDS – A CDS contract where the underlying is a syndicated loan, senior secured in the capital
structure.
LIBOR – London Interbank Offered Rate – An interest rate paid by high-rated borrowers, such as
international banks. Somewhat of an international equivalent to the US Fed Funds rate, it is used as a
reference rate for many transactions, including credit derivatives.
Long Credit – Refers to the position of the CDS Protection Seller who is exposed to the credit risk and
who receives periodic payments from the Protection Buyer.
Markit CDX – Markit credit indexes focused on North America. High Grade, High Yield, and Emerging
Markets are the three major sub-indexes.
Markit iTraxx – European and Asian CDS indices owned by Markit. iTraxx represents the most liquid part
of the CDS market for Asia and Europe.
Markit RED™ – Markit’s Reference Entity Database of approximately 3000 reference entities forming the
basis of the RED code identifiers for CDS.
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Markit Credit Indices Primer
MCDS – A CDS contract where the underlying is a municipality, and the reference obligation is either a
Revenue Liability, a General Obligation Liability, a Moral Obligation Liability or a Full Faith and Credit
Liability.
Notional Principal – The quantity of the underlying asset or benchmark to which the derivative contract
applies.
Present Value – An asset valuation method, which maps future cash flows from an asset and discounts
the future cash flows by an appropriate discount rate.
Protection Buyer – This is the party to a CDS contract which pays a premium for protection in case a
credit event occurs. The Protection Buyer can also speculate that the cost of protection will rise and profit
from selling the CDS contract at a higher price than was paid.
Protection Seller – This is the party to a CDS contract receiving the premium payments, and who is
exposed to the credit risk of the reference entity.
Quorum – Quorum represents a 75% majority of members when making decisions in regards to a Markit
credit index.
Recovery rate – Estimate of percentage of par value bondholders will receive after a credit event. CDS
for investment grade bonds generally assume a 40% recovery rate. However, CDS for lower rated bonds
are more dynamic and often reflect lower estimated recovery rates.
RED Code - Industry standard identifier for CDS contracts. They are 9 character CUSIP-like codes where
the first 6 characters refer to the reference entity, and the last 3 refer to the reference obligation. RED
codes are used by DTCC to confirm CDS trades on the DTCC Deriv/SERV platform.
Reference Entity – Refers to the legal entity that is the subject of a CDS contract. The reference entity
can be the issuer or the guarantor of the debt.
Reference Obligation – The specific bond (debt obligation) that is referenced in the CDS contract
Restructuring Credit Event – One of the types of credit events (defined above). It is a “soft” event, in
which the loss to the owner of the reference obligation is not obvious. In addition, restructuring often
retains a complex maturity structure, so that debt of different maturities may remain outstanding with
significant differences in value.
Settlement – What occurs in the case of a credit event. Settlement can be cash or physical delivery,
depending on the terms of the contract. CDS have most often specified physical delivery, but in the last
three years, auctions have been held and cash settlement is becoming the standard.
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Short Credit – This is the credit risk position of the Protection Buyer, who sold the credit risk of a bond to
the Protection Seller.
Spread – A generic term describing the difference, generally in basis points, between the levels of two
reference values. For example, it can be a dealer’s bid-ask spread or a yield spread (the difference
between yields on different debt instruments).
Swap – An agreement between two parties to exchange future cash flows.
Tenor – Refers to the duration of a Credit Default Swap contract. Most CDS have been written with 5
years terms, and this remains the most liquid and frequently quoted part of the credit curve; however
other tenors, such as 10 years, are becoming more common.
Tier – Refers to one of four levels of debt in the capital structure of the reference entities. Each tier
represents a different level of seniority or preference in liquidation or bankruptcy. There will generally be
different levels for CDS protection for each of the tiers.
•
•
•
•
Senior
Subordinated
Junior
Preferred
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